Advantages and development prospects of algorithmic stablecoins: Is it the "currency" that best fits Satoshi Nakamoto's vision?

Satoshi Nakamoto introduced a peer-to-peer electronic cash payment system in the Bitcoin white paper, but Bitcoin has deviated from this original electronic currency design; ETH has certain transaction medium attributes, but it is essentially an application token and it is difficult to achieve the design requirements of currency in the blockchain. Although the central bank's digital currency has blockchain attributes, it is still a centralized currency with strong supervision.

Odaily Planet Daily believes that the current algorithmic stablecoin is most likely to become the "currency" designed in Satoshi Nakamoto's white paper, and is currently the native cryptocurrency that is more in line with the spirit of blockchain decentralization. Why do you say that? How is it different from previous generations of stablecoins? Where will the algorithmic stablecoin go in the future? We will explain them one by one below.

Bitcoin deviates from Satoshi Nakamoto’s idea of ​​currency, and ETH has no intention of serving as

In the context of the digital age, Bitcoin has deviated from the "currency" envisioned by Satoshi Nakamoto. The current transaction payment cost of Bitcoin is actually very expensive, which is far from what Satoshi Nakamoto envisioned. To date, few people have mentioned the expansion of the Bitcoin block.

Bitcoin has abandoned the "currency" role envisioned by Satoshi Nakamoto, but is moving towards the path of digital gold in the crypto world, and has acquired safe-haven properties. Grayscale pointed out in its report "The Great Transfer of Wealth Pushes BTC to Become a Mainstream Investment Target" that Bitcoin seems to have some similarities with safe-haven assets, such as: 1. Scarcity; 2. Verifiability; 3. Not much correlation with traditional financial markets and uncontrolled.

Once upon a time, Bitcoin as digital gold was only in people's imagination, but now, traditional institutions have regarded BTC as digital gold. On November 9, JPMorgan Chase pointed out in a report that Bitcoin is eroding the market demand for gold ETFs. Institutional investors such as family offices regard Bitcoin as a digital substitute for gold, and their demand for Grayscale's Bitcoin Trust also exceeds the total demand for all gold ETFs.

In the future, as the pegged coins and cross-chain technologies mature, Bitcoin will further realize the function of value storage in the blockchain network. After Ethereum solves the problems of slow transfer speed and high handling fees, Bitcoin is expected to achieve efficient circulation in the form of pegged tokens, and will not be blocked in its own small blocks; if cross-chain technology matures, Bitcoin can further circulate in the blockchain world (although this circulation is still in the role of digital gold, not currency).

So, is it possible for Ethereum, the second largest crypto asset, to become the "currency" envisioned by Satoshi Nakamoto? The positioning of Ethereum and Bitcoin has been very different from the beginning, and Ethereum has never intended to become a "currency" in the blockchain network. Although ETH does serve as a transaction medium in some scenarios during the development of Ethereum, the value of Ethereum depends on the application value of its underlying network. The price of ETH is very uncertain, and it is difficult to play the role of "currency". Take the 312 crash this year as an example. MakerDao uses ETH as a collateral asset, but because of the sharp price fluctuations, asset liquidation, network congestion, chain liquidation followed, forming a huge systemic risk. ETH is actually more like the "energy" of the Ethereum network, and it may be more appropriate to be regarded as an application token.

The times have chosen Bitcoin to serve as digital gold, and Ethereum is committed to becoming a blockchain infrastructure with a very clear goal. So who should play the role of "currency" envisioned by Satoshi Nakamoto? This issue is still controversial in the market, and we believe that stablecoins may be the closest to it at present.

The evolution and development of stablecoins

The essence of the "currency" envisioned by Satoshi Nakamoto is a decentralized cryptographic native token based on cryptography. Although digital currencies issued by commercial institutions or central banks use blockchain technology, they have strong centralized attributes; algorithmic stablecoins are cryptographic native tokens that are more in line with Satoshi Nakamoto's vision. Before introducing algorithmic stablecoins, let's review the evolution and development of stablecoins to observe how stablecoins have gradually realized the "currency" form envisioned by Satoshi Nakamoto.

• The representative of the first generation of stablecoins is USDT, which tokenizes fiat currency and builds an important bridge between fiat currency and cryptocurrency.

• The second generation of stablecoins attempts to build decentralized stablecoins, one of which is MakerDAO's DAI. MakerDAO used ETH as collateral in the early days, and later introduced some centralized assets as collateral based on market risk considerations, such as USDC and wBTC. After the introduction of centralized assets, DAI has gained stronger stability, but it has also sacrificed some decentralized features.

• The third generation of stablecoins attempts to build native tokens for the cryptocurrency industry, represented by AMPL and YAM’s elastic stablecoins, which do not require collateral and are mainly regulated by algorithms and mechanisms. The third generation of stablecoins is very close to the “currency” envisioned by Satoshi Nakamoto, and it will also become a strong competitor for blockchain “currency” in the future, but we are more optimistic about algorithmic stablecoins.

• The fourth generation of crypto-native algorithmic stablecoins are mainly represented by ESD, BASIS, FRAX, etc. This type of algorithmic stablecoin refers to the previous design of Basecoin and combines the experience of liquidity mining and elastic stablecoins, thus showing a trend of integration.

Advantages and disadvantages of first-generation and second-generation stablecoins

Although the four generations of stablecoins mentioned above can all be said to be anchored to the US dollar, they are essentially different and can be roughly divided into two categories: the first and second generation stablecoins belong to the collateral anchoring mechanism, which is pegged to the US dollar at a 1:1 ratio through asset collateral. The price difference between these two types of stablecoins and the US dollar remains within a very small fluctuation range; in the third and fourth generation stablecoin systems, the US dollar price is actually only equivalent to the reference price. Stablecoins are essentially based on algorithms and market adjustments to find a price equilibrium point, which currently makes their fluctuation range relatively large.

Although both the first and second generation stablecoins are mortgage-anchored tokens, what is the difference between them? What are the advantages and disadvantages of this type of stablecoin? Why are the third and fourth generation stablecoins more promising?

The first generation of stablecoins is a completely centralized collateral anchoring model. Its issuing institution is centralized, and it issues stablecoins 1:1 by reserving US dollars (equivalent to collateralizing US dollars). Although the second generation of stablecoins is also 1:1 anchored to the US dollar, its collateral assets are mainly crypto assets, and it maintains the anchor price through the automatic pricing mechanism built into the smart contract, rather than through the issuing entity. In other words, the second generation of stablecoins transformed the centralized stablecoins into a decentralized collateral anchoring model.

The collateral-anchored stablecoin builds a bridge of communication between traditional assets and crypto assets; at the same time, it establishes its own stable currency unit for the volatile crypto world. The role of this medium of circulation temporarily plays the role of "currency" designed by Satoshi Nakamoto, but this is only temporary.

One of the disadvantages of the collateral anchor model is its centralized nature (even the second-generation stablecoin DAI has to sacrifice decentralization to a certain extent and introduce centralized assets in the collateral assets to ensure stability). Another "drag" of the collateral anchor model is that it is not suitable for the crypto world that is about to explode. Looking back at history, the stablecoin collateral anchor model is very similar to the US dollar system during the establishment of the Bretton Woods system (35 US dollars anchored to 1 ounce of gold). In the process of wealth migration in the digital age, collateral anchored stablecoins are very likely to move towards anchor decoupling or collapse. In fact, the decoupling we are discussing is happening. For example, it is difficult for Tether to always guarantee a 1:1 exchange rate between USDT and the US dollar. This is another reason why this article believes that the third and fourth generation stablecoins are more promising.

Why are the fourth-generation stablecoins more advantageous?

Compared with the first and second generation stablecoins, the third and fourth generation stablecoins abandoned the collateral anchoring model and instead established a "currency" system through market supply and demand.

Let us first introduce in detail the operating mechanisms of the third and fourth generation stablecoins.

The third generation of stablecoins is elastic stablecoins. Taking AMPL as an example, its basic operating mechanism is introduced. AMPL is issued based on Ethereum smart contracts. The most important part of the AMPL protocol is the "token base readjustment" mechanism, which can automatically adjust the number of AMPL tokens in all user wallets according to market prices. This adjustment does not cause token dilution, but increases or decreases in the same proportion. The adjustment is mainly based on changes in market supply and demand, and then through the transmission of price information, people are prompted to gamble and arbitrage, thereby prompting AMPL to find a price balance point. People buy AMPL because they hope it will rise, so as to obtain more tokens for profit, which leads to a very strong speculative atmosphere in the AMPL market. AMPL's global adjustment is a bit rough, and once most people start to panic and sell, it is very easy to cause systemic risks. AMPL is very innovative and tries to find the native currency of the crypto world through market supply and demand, which is worthy of recognition; but this attempt lacks experience and is highly speculative, and is not suitable as the "currency" envisioned by Satoshi Nakamoto.

The fourth generation of stablecoins is algorithmic stablecoins. Algorithmic stablecoins refer to the previous design of Basecoin and combine the experience of liquidity mining and elastic stablecoins to form a relatively complete monetary market regulation mechanism. Unlike the third generation stablecoins AMPL and YAM, the token adjustment of the fourth generation stablecoins ESD and BASIS is not a global adjustment through smart contracts, but is completed by users actively, and economic incentive mechanisms are used to stimulate user behavior.

Let's take the algorithmic stablecoin BASIS as an example. There are three tokens in the Basis protocol: BAC (abbreviation of Basis Cash), BAS (abbreviation of Basis Share), and BAB (abbreviation of Basis Bond). Among them, the target price of BAC is $1; the main function of BAS and BAB is to pull the price of BAC back to $1. Holding BAS can get new stablecoin rewards, which is equivalent to enjoying seigniorage; BAB has the opportunity to obtain premium income.

Specifically, when the transaction price of Basis Cash is lower than $1, users can enjoy a certain discount to purchase Basis Bond. Users purchase Basis Bond (BAB) and destroy Basis Cash (BAC) at the same time, thereby reducing the supply of BAC and pulling the price of BAC back to $1. When the price of Basis Cash rises above $1, users holding Basis Bond can directly redeem Basis Cash at a 1:1 exchange rate. When Basis Cash is redeemed by the user, Basis Bond will be destroyed. Basis Bond has no interest expenses and no maturity or expiration time. This market regulation mechanism of algorithmic stablecoins well guarantees the credit of its minted currency and makes it easier to achieve "currency" stability.

The design of algorithmic stablecoins is generally similar, but there are some subtle differences, such as the expiration date of coupons in ESD (similar to BAB); in addition, there are differences in epoch time and lock time. These will lead to different price deviations, market speculation, and market regulation mechanism flexibility, and ultimately develop different trajectories. In the competition among many algorithmic stablecoins, the market will select the best "currency".

According to our observations, the fourth-generation algorithmic stablecoins are more "stable" than the third-generation elastic stablecoins.

First of all, algorithmic stablecoins draw on the design of Basecoin and are very reasonable. At the same time, they also combine the experience of liquidity mining and elastic stablecoins to form a relatively complete "currency" adjustment mechanism based on changes in market supply and demand, which is more similar to the "currency" function envisioned by Satoshi Nakamoto. Which algorithmic stablecoin can become the leader in the future still needs to wait for market selection; however, judging from the development trajectory of DeFi, the first-mover advantage is still very important. If latecomers just blindly imitate or "micro-innovate", the value will be relatively limited, and the risk of user participation will also be relatively large.

How will algorithmic stablecoins develop in the future?

Algorithmic stablecoins are still in the early stages of development, and it is difficult to say how they will develop in the future, but some predictions can be made based on phenomena observed in recent days.

We believe that the anchor point of algorithmic stablecoins may deviate from one dollar in the future . Emin Gün Sirer, founder of Avalanche Protocol, tweeted yesterday: Algorithmic stablecoins may indeed have an anchor point, but this value is not necessarily $1. He also cited the example of DSD to illustrate that DSD is currently trading at $0.38, and there are not enough DeFi participants to raise its price to $1. When DSD is above $0.38, these people will think they have made enough money and sell when they think DSD is above the entry level of others.

This phenomenon is caused by the existence of a complete "currency" adjustment mechanism within the algorithmic stablecoin, and this adjustment mechanism is essentially determined by market supply and demand. The US dollar price is more of a reference price in the algorithmic stablecoin system, so the algorithmic stablecoin does not have to be anchored to the US dollar price. At present, the scale of algorithmic stability is still small and the volatility is relatively large; but according to observations, as the volume of algorithmic stablecoins expands, the volatility of algorithmic stablecoins is also decreasing. After algorithmic stability is more widely adopted, a more accurate anchor point will also emerge. At this time, the volatility of algorithmic stablecoins will also be greatly reduced, so that they will be widely exposed to the crypto market, and a complete "currency" system will also mature. By then, algorithmic stablecoins, DeFi, Bitcoin and other crypto assets will be combined to form a complete crypto economy.

In addition, we believe that algorithmic stablecoins anchored to a basket of fiat currencies may appear in the future . On the one hand, the dollar is declining, and there is diversified competition in the currencies of the traditional financial market. A basket of currencies can better reflect the monetary value of assets; on the other hand, the "currency" in the crypto market is naturally borderless and benchmarked against global assets, so it does not have to be anchored to the US dollar. If it can be more diversified, it can also better adapt to the diversified development of the crypto market in the future.

Algorithmic stablecoins are still in the experimental stage. If they are to achieve long-term and stable development, they require broad and long-term consensus.

From the user's perspective, early participation can bring high profits, but also faces high risks. For example, the tokens in the algorithmic stablecoin system generally have high premiums and are likely to fall sharply in the future. In addition, the security and applicability of the contract are yet to be tested by the market, and investors should participate with caution.